Is IBM too Focused on Hitting Earnings?

Why IBM disappointed in the last quarter, why it wasn't so bad, and a look at how IBM is adjusting its business in order to hit its earnings targets.

It's easy to criticize Wall Street for being too myopic and focused on near-term targets, but is IBM (NYSE:IBM)doing this too? IBM has laid out a specific set of metrics that it intends to hit, and it could be forcing its management to damage its long-term business development by hitting them. It's time to look more closely at what's going on at IBM, and whether its underlying business is being compromised or not.

Why IBM disappointed in its first quarterIt's no surprise that the first quarter conference call saw analysts asking question after question regarding how IBM intends to hit its targets. After all, the company's management has laid them out repeatedly, and appears to want to be judged by them.

For ease of reference, they are:

Non-GAAP diluted EPS of at "at least" $18 for 2014, putting it on a forward P/E ratio of 10.5 times earnings

These targets were confirmed on the conference call and results statement, but Fools need to look beyond the headline data. In actuality, the affirmation of an EPS target around $18 is a relative downgrade to the previous quarter. The reason being that at the time of its fourth quarter results, IBM's management had expected a tax rate of 23% for 2014. Now, it expects an annual rate of just 20%.

To put this into context, an $18 EPS with a 23% tax rate implies a pre-tax earnings equivalent to $23.40, while $18 with a 20% tax rate implies a figure of $22.50. In other words, a lowering of 3.7% in pre-tax earnings. Therefore, don't get too excited by the affirmation of EPS guidance as its de-facto a slight downgrade.

Three reasons why it wasn't so bad Furthermore, the headline trends in IBM's businesses appear to be moving in the wrong direction. A cursory look at the revenue growth rates within its trading segments reveals some tough trading conditions.

Source: IBM Presentations

There are three mitigating factors to this horrible-looking chart.

The first is that IBM strongest growth –albeit a paltry 1.6% in the quarter—is coming from its most profitable segment (Software), while its weakest segment (Systems and Technology) is seeing the worst declines. A look at first quarter segmental income demonstrates the point:

Source: IBM Presentations

The second factor is that much of the revenue and profit decline was due to restructuring efforts. As an example, management had the following to say about its services (global technology and global business) profits during the conference call:

Services pre-tax profit was down 14% and margin declined by 1.9 points. Without the workforce rebalancing charges in both years, profit was up 7% and margin expanded by 1.5 points.

In other words, the underlying trends are more positive than the headline data suggests. In addition, non-GAAP net income did decline from $3.37 billion to $2.64 billion, but the results included an $870 million hit from workflow rebalancing. Adjusting for this, and a $100 million gain for the sale of as business, means that the numbers were pretty flat year-on-year.

The final factor is that IBM continues to invest in its growth platforms in a manner that suggests it can utilize its powerful cash generation in order to generate growth in future. For example, its cloud based revenue increased more than 50% and business analytics revenue increased more than 6%. Foolish investors can find out more about business analytics companies in an article linked here.

As for the cloud, IBM is committed to investing $1.2 billion in order to increase its global cloud footprint and expand its services in the burgeoning infrastructure as a service (IaaS) market. Meanwhile, IBM continues to divest unwanted businesses, as with the planned sale of its standard server business (hardware) to Lenovo.

The bottom lineIt wasn't a great quarter for IBM, but it has kept its full-year guidance intact. It's been a while since IBM reported a strong quarter, and there will be concerns that its businesses will continue to decline. On the other hand, we invest in companies so that the management will deliver what they say they will do. Furthermore, the restructuring plans and divestitures make sense, while the investments in growth areas are in line with what you would expect a company of IBM's resources to be doing.

IBM isn't compromising its business by trying to hit these targets so much as changing how it gets there. On balance, the results were disappointing and the company's stock got hit accordingly. If IBM can hit its full-year targets, though, then its stock still looks like a good value.

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